A Phantom Share Scheme (‘PSS’) gives a company employee contractual rights to be paid a certain amount of bonus cash. This bonus is based on an increase in a company’s share price or value. It is a tool to incentivise and retain talent without giving up any real equity in your company. Compared to Employee Share Schemes (‘ESS’), a PSS is a much simpler plan and is less expensive to implement. Additionally, the tax treatment of a PSS is less complicated than implementing an ESS. Moreover, unlike ESS, you do not have to grant your employees any interests in or own any company shares. This article explains what is a PSS and how it works.
What is a PSS?
PSSs cater to employers who wish to incentivise and retain their talent without giving up equity in the company. Under a PSS, you issue employees ‘fake shares’ tied to the value of the company’s real shares. Typically, you will pay your employee when the real shares of the company increase in value or pay a dividend.
Implementing a PSS
A PSS is relatively easy to establish since they do not grant employees shares in a company. They are often profit-sharing or improvement-sharing schemes, commonly added as an addendum to an employee’s terms of employment.
Under a PSS, you will not issue or transfer equity in your company. There are no limitations on how much profit you may share with your employees. Where a PSS is tied to an increase in the real share price, whereas ESS milestones are tied to date with vesting provisions. Nevertheless, income tax will apply when your employee receives a payment under your PSS.
Continue reading this article below the formWhen Will I Pay My Employees?
Under a PSS, you can either pay your employee on an ongoing basis or at a specific trigger event, such as if you sell your business. Paying your employees an annual cash payment under your PSS is akin to a dividend. That is to say, the payment reflects the dividend they would receive if they were a company shareholder.
Tax Treatment of PSSs
Tax law treats phantom shares as cash bonuses deferred until a future milestone or event. When the phantom shareholder reaches an established event (i.e. when the employee leaves your company), you will pay out an amount to the employee under your scheme. When you make the payment, the law considers it ordinary income in the hands of the employee (without any tax concessions). Additionally, it could a tax deduction for your company.
Differences Between a PSS and an ESS
An ESS is a scheme where you provide your valued employees with shares, or the right to acquire shares (options), to recognise their value to your company. An ESS is more sophisticated and complex to set up compared to a PSS.
With an ESS, you must draft several critical legal documents, including a:
- letter of offer; and
- summary of the ESS given to the relevant employees.
With an ESS, you might also need to amend your shareholders agreement to allow the adoption of the ESS. There are also higher administrative costs in running an ESS due to your ongoing reporting requirements, mainly if you must meet vesting requirements. Finally, at some stage with an ESS, you will have to go through the governance steps associated with issuing options or shares.
LegalVision’s Employee Share Schemes Guide is a comprehensive handbook for any startup founder or business owner looking to attract and motivate top employees with an Employee Share Scheme.
Key Takeaways
Phantom Share Schemes (‘PSS’) can be valuable tools to incentivise and retain your key talent. They are more straightforward to implement than an Employee Share Scheme. In addition, they do not result in any ownership dilution to you and other existing shareholders. If you are interested in setting up a Phantom Share Scheme, our experienced corporate lawyers can assist as part of our LegalVision membership. You will have unlimited access to lawyers to answer your questions and draft and review your documents for a low monthly fee. Call us today on 1300 544 755 or visit our membership page.
Frequently Asked Questions
You are not obliged to enter into any form of Employee Share Scheme. However, they are a useful tool startups can use to attract and retain talent despite not being able to offer the same salary as an established corporation. In Australia, it is a commonplace for startups to implement an Employee Share Option Plan (ESOP) leading up to their seed raise.
This will depend on the type of company and whether you intend to sell your company. For early-stage startups, receiving shares or options under an Employee Share Scheme could be a big payout if the company is acquired or listed on a public exchange. On the other hand, if you have no intention of selling your business, a Phantom Share Scheme may be more desirable, as the value of the shares in your employees’ hands is only realised if you sell the company or list it on a public exchange. Furthermore, from a tax perspective, an Employee Share Scheme is more favourable as, if you meet specific tax office criteria, your employees may be entitled to tax concessions.
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